The Week Ahead, November 1st

• stevenplace
• November 1st, 2009

The Risk Aversion Trade

With the recent volatility during the second half of last week, I think it’s helpful and take a step back to gain perspective on the markets. As I’ve mentioned before, the Liquidity Conveyor Belt has been my overall thesis as evidenced of the price action since march. This trade is also known as the reflation trade, or the risk trade. Essentially it’s long equities and commodities, short treasuries and dollar. This trade has been in a trend for quite some time, but we are starting to see cracks in that trade.

Equities have seen some technical damage done, and it probably indicates exactly what sort of market we are facing going into EOY: neutral to bearish, with a splash of volatility. My thesis going into the end of the year was that volatility would continue to come out, and although there was signs of equity risk, that we would be more rangebound going into December. My thesis so far has been proven half right: vol has seen an uptick, and while we are “collapsing” I feel that we could be knocking out a range to trade around. The range just may be a little wider (and a little more tradeable) than I had thought.

So first let’s take a look at overall equity markets:

RUT

I start with the Russel for a few reasons. First, it failed to confirm new highs and created a double top. It also led the overall market lower, so if the markets are to find an intermediate term bottom, this must first lead the bottom. The fact that the Russel failed to retake the highs from Wednesday on Thursday while other indices did was evidence of a lack of overall demand. But most importantly is that it measures the risk aversion trade. If investors and traders are looking to chase after gains, small-cap-high-beta-hand-grenades will see more demand compared to “boring” names.

So in terms of technicals there are a few things on this chart:

Double Top. The chart found an equal level of resistance at 624 and failed to hold support at the October lows of 576. It took approximately 7 weeks for the pattern to form. So the measured move is about 50 points from the breakdown, and we should expect that price target to be hit within about 7 weeks. So we’re looking at 525-530 by December.

Previous Resistance. We have a couple critical levels. First is from the highs back on January 6th at 519. That coincides with the right shoulder of the failed head and shoulders pattern from July. There is also the top of the head and shoulders pattern around 530. These price levels add confluence to the price target established by the double top.

Fib Retracement. Retracing about 1/3 of the move from March would put us at 516.

200 DMA: The 200 DMA which has yet to be retested since July will be creeping up towards those price levels around December-ish.

20/50 Cross: This hasn’t happened but only briefly in mid summer, and this looks like it will be sustainable.

So with the current evidence, it seems that we have broken the major trend, and we have a very clear level in which we should expect price to hit by EOY: 520-530.

With that said I still believe it’s unwise to go full on bearish and short here. Given the current rate of change (from the 5DMA) we would reach those levels in 3 weeks. We’ve seen price velocity like that, but it was under different market conditions (crash) and I believe there is much liquidity still to reduce the overall rate of descent.

I’m going to forego the other major indicies because the same sort of analysis applies, but here is the risk aversion evidenced by the underperformance of smallcaps to the S&P:

The trend has rolled over, but we’ve hit the 3 standard deviation bollinger band, which I feel shows exactly how oversold the market currently is.

Speaking of oversold:

Since May, we’ve closed outside of the Bollinger Band 4 other times:

• 8/17
• 9/1
• 9/2
• 10/2

All of these dates have been major intermediate term bottoms in the equity market. The thing that has changed this time is that we’ve gone from an uptrend to a more neutral/bearish trend.

So my shorter term outlook remains a slight paradox: trend change, but oversold. I am expecting a bounce going into the first half of the week, and a potential failure. From a sentiment perspective, the trendline break short is entirely too simple; if you’re going to make money shorting the market, it’s going to be tough.

Trade setups to come later tonight.

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